Cash Balance Conversions And Other “Greater of”
Formulas
By Carol H. Jewett, Esq. and Felicia A. Finston,
Esq.
Vinson & Elkins LLP, Houston, TX and
Baker Botts LLP, Dallas, TX
Background
On September 15, 1999, the Internal Revenue Service (IRS) issued a
field directive which suspended the processing of all open
qualification determination letter applications and examination cases
that involved plans which had effected a conversion from another
defined benefit plan formula into a cash balance formula. The original
purpose of suspending these proceedings was to give the IRS the
opportunity to review a number of cash balance plan and cash balance
conversion issues which were of concern both to the IRS and Congress,
relating to age discrimination, the so-called “whiplash”
effect and accrued benefit cut backs. Pursuant to field directive,
determination letter applications involving such plans were referred
to the National Office of the IRS. The cash balance plan determination
application moratorium was lifted in December of 2006. At that time
there were over 1000 cash balance plan determination applications
pending and the IRS made processing these pending applications a high
priority matter. There were, however, a few technical issues affecting
certain types of cash balance plans which were still under
consideration by the IRS. Among these was the issue of how a plan
which combined a cash balance accrual formula with some nature of
additional formula for all or certain participants could satisfy the
backloading requirements of Section 411 of the Internal Revenue Code
of 1986, as amended (the
“Code”).1 Such dual
formula situations could exist under a plan as a result of a simple
minimum benefit protection or as a result of a grandfathered extension
of the plan's prior benefit formula to an identified group of
participants to give them special protections in connection with the
conversion of the plan from the prior formula to a cash balance
formula.
Following termination of the cash balance plan determination
application moratorium, plans having dual formulas which combined a
cash balance formula with either a minimum benefit formula or a
grandfathered prior formula initially were requested to demonstrate
that the two formulas as combined would satisfy the §411
backloading requirements. An example of the request being made of
these plan sponsors was: “Since the plan has a minimum benefit
formula that continues to accrue after the plan's conversion to a cash
balance formula, it may need to aggregate the continued minimum
benefit formula and the post-conversion cash balance formula to test
if they, together, satisfy the 1331/3% accrual rule.”
Informally, the IRS indicated that it felt that such dual formula
plans likely would not satisfy the §411 backloading requirements
because, when both formulas were combined and accumulated, some
participants would experience a temporary dip in their accrual rate
when one formula overtook the other as, for instance, when a
traditional retained formula applied only for a limited time or when
both formulas applied permanently but one is overtaken by the other
during a participant's later period of planned participation.
Actuaries and consultants protested the approach being taken by the
IRS on the application of the §411 backloading requirement to
dual formula plans both as being unnecessary in terms of technical
application of the §411 requirements and as a matter of equity
given that the overwhelming majority of dual formula plans are
structured for the benefit of the participants to provide them with
benefit protections.
Revenue Ruling 2008-7
On February 1, 2008, the IRS issued Rev. Rul. 2008-7, 2008-7 I.R.B.
419, which applies a §411 backloading analysis to a specific fact
situation involving a defined benefit plan which was converted from a
traditional final average pay time years of service formula to a cash
balance formula with a grandfathered protection providing continued
application of the final average pay times years of service formula
for one group of employees. As analyzed by the IRS, the plan satisfied
the §411 backloading requirements for the year of testing. The
revenue ruling, while helpful in clarifying the issue of backloading
with respect to cash balance plans using “greater of”
formulas, is limited in its scope and will not provide comfort to plan
sponsors who are in the process of developing plan designs that
include multiple defined benefit formulas or converting an existing
defined benefit plan to a cash balance
plan.
Application of Backloading Testing Requirements
In its analysis of the application of these alternative tests to
the plan in issue, the IRS first noted that benefits under all
formulas that are applicable to a participant must be aggregated for
purposes of the backloading testing rules and that even if one formula
that is applicable to a participant by itself would produce a benefit
that satisfies the 1331/3% rule and the other formula by itself would
produce a benefit that satisfies the fractional rule, the total
benefit provided by the interaction of the two formulas must accrue in
a manner that satisfies at least one of the three alternative methods.
As the lynchpin of its analysis concluding that the plan being
analyzed satisfies the backloading requirement of §411, the IRS
points out that if the benefits of all participants do not satisfy the
same accrual rule, a plan is permitted to satisfy one of the accrual
rules for some participants and another accrual rule for other
participants as long as the different classification of participants
is not structured so as to evade the §411 backloading
requirements.
Application of Rules to Plan at Issue
Applying this rule to the plan being considered, the IRS divided
the plan's participants into three groups consisting of: (i) those who
became employed after the date the plan was converted to a cash
balance formula and who, therefore, would accrue benefits only under
such formula; (ii) those who were not grandfathered participants (by
virtue of not satisfying the age and service requirements for the
grandfathering to apply) and who were employed after the plan's
conversion to a lump sum formula who, therefore, would accrue some
benefits under the new cash balance formula but whose prior conversion
benefits were “frozen” under the pre-conversion formula;
and (iii) those who were grandfathered participants and would accrue
benefits after the plan's conversion to a cash balance formula under
both the pre-conversion formula and the new cash balance formula for a
limited period of time.2 In the
remainder of the revenue ruling, the IRS applied an analysis of the
backloading rules consisting of demonstrating that the first group of
employees (i.e., the individuals who were first employed on or after
the date of the plan's conversion) satisfied the 1331/3% backloading
rule and that the accruals for the participant's who were employed
prior to the plan's cash balance conversion date but who were not
grandfathered would, similarly, satisfy the 1331/3% rule. Turning to
the last group of participants in the fact situation, the IRS divided
these into three separate groups consisting of: (a) the group of
participants who were grandfathered and who were age 61 or older in
the year of testing; (b) the participants who were less than age 61 in
the year of testing but who did not accrue additional benefits under
the cash balance formula before normal retirement age (such that their
benefit did not shift from one formula to another); and (c) the group
of grandfathered participants below the age of 61 who would accrue
additional benefits under the new cash balance formula before normal
retirement age. The revenue ruling demonstrates that the first two of
the three groups of the grandfathered participants satisfied a
straight application of the 1331/3% rule but that the third group
would not.
Limited Usefulness of Fractional Rule
Pointing out that the fractional rule could not be effectively used
on a permanent basis for the plan in issue for reasons discussed in
the revenue ruling, the revenue ruling nonetheless points out that the
post-lump sum conversion transitional benefit accruals under the
pre-lump sum conversion formula for a limited and temporary period
might result in a pattern of benefit accruals that would satisfy the
fractional rule on a temporary basis for the third group of
grandfathered participants. The revenue ruling discusses the
application of the fractional rule in some detail and then
demonstrates that, for the testing year in issue, the application of
the fractional rule would, in fact, result in this last group of
grandfathered participants having benefit accruals which did not
contravene the backloading requirements of
§411.
Prospective Plan Changes May be Required
At the end of the revenue ruling, the IRS includes some cautionary
notes. Principal of these is the caveat that the analysis and holding
in the revenue ruling only addressed one plan year in terms of
demonstrating that the plan's benefit formulas satisfied the
backloading requirement of §411 and that it is possible that the
plan would fail to satisfy the backloading rules for a subsequent year
either due to changes in relevant factors that are treated as constant
for any given year or due to changes in facts relating to plan
participants. The revenue ruling includes examples of these possibly
relevant factors. The revenue ruling also notes that if backloading
rule requirement problems should arise in the future with respect to
the plan, it is possible that the plan's benefit formula would need to
be changed to cause the plan to continue to satisfy the backloading
requirements and that any such change would need to satisfy applicable
qualification requirements including satisfaction of the anticutback
rules and the requirements that a plan provide benefits that are
definitely determinable. The revenue ruling includes examples of
benefit formula changes which might be effected to alleviate a future
backloading problem should one arise.
Relief Provided
Finally, the revenue ruling provides §7805(b) relief as
against disqualification for certain plans under which a group of
employees specified under the plan receives a benefit equal to the
greatest of the benefits provided under two or more formulas provided
that each such formula standing alone would satisfy one of the three
backloading requirement tests. This relief applies to a plan only if:
(1) as of February 19, 2008, the plan provisions under which the
applicable greater of benefit formula is provided have been the
subject of a favorable determination letter; (2) as of February 19,
2008, a remedial amendment period under §401(b) for the plan
provisions under which the applicable greater of benefit formula is
provided has not expired; or (3) the plan is otherwise a moratorium
plan as defined in Notice 2007-6. If applicable, this relief applies
only for plan years beginning before January 1, 2009 and does not
extend to other issues under §411.
Limits of Ruling
The retrospective relief in the revenue ruing does not apply to
formulas not in place on February 19, 2008 or plans that do not have a
current or pending determination letter. Accordingly, existing
converted plans that do not have a current or pending determination
letter may need to modify their existing formulas to ensure that each
formula separately satisfies an accrual rule. In addition, plan
sponsors who are contemplating adopting a multiple formula defined
benefit plan or converting an existing defined benefit plan to a cash
balance plan are not protected in adopting plan design changes in
reliance on the revenue ruling. Rather, such sponsors should wait
until the IRS issues proposed regulations regarding application of the
backloading rules to defined benefit plans with multiple formulas.
Guidance is expected to be issued that will allow separate testing
with respect to cash balance conversions like the one analyzed in Rev.
Rul. 2008-7 and other “greater of” formulas under proposed
regulations that will be effective for plan years beginning on and
after January 1, 2009. Unfortunately, it is not clear what kind of
“greater of” formulas the IRS intends to approve in these
regulations and it is possible that Rev. Rul. 2008-7 is a prequel to
regulations that will only provide relief to “greater of”
formulas that satisfy narrow design criteria.
For more information, in the Tax Management Portfolios, see
Brown, 352 T.M., Specialized Qualified Plans -- Cash Balance,
Target, Age-Weighted and Hybrids, and in Tax Practice Series, see
¶5560, Specialized Retirement Plans.
1
By way of background, the backloading requirements of §411 are designed to prevent disproportionate accruals for a participant in the participant's later years of plan participation as compared to the participant's earlier years of plan participation. The rules provide alternative ways that a plan sponsor may demonstrate that the benefit formula under a plan which affects a participant does not have a prohibited backloading effect. These formulas are the 3% method of §411(b)(1)(A), the 1331/3% rule of §411(b)(1)(B) and the fractional rule of §411(b)(1)(C).
2
The facts stipulated that the continued application of the plan's prior formula would extend for a five year period if that provided the greater benefit than the benefit provided by the combination of the initial account balance created by converting the conversion date accrued benefit into an opening account balance plus the cash balance compensation and interest credit for the grandfather five year period.
|
